Broadway Financial Could Improve But Is Currently Too Risky

Summary

• BYFC has recently merged with First City Bank from Washington. The bank's combined asset base could dilute its non-interest costs and improve profitability.
• However, BYFC has shown bad loan allocation policies in the past, generating substantial losses during the GFC, of up to 10% of the book.
• The company also faces short-term risks, like enormous non recognized losses on its books, and the accrual effect of CECL loan loss recognition.
• Because of its fixed rate mortgage book, the bank is not currently benefiting from the increase in interest rates.
• The bank's biggest advantage is access to a very cheap deposit base that makes up almost 90% of its interest bearing liabilities.

SDI Productions

Broadway Financial Corp (NASDAQ:BYFC) is a California-based bank that recently merged with First City, a Washington-based bank. Both companies concentrate on lower and middle income client multifamily mortgages.

BYFC has a history of under profitability caused by a small asset base that was not big enough to sustain its non-interest expenses. After the merger with First City, the situation may improve. The main advantage of the combined company is the low cost of its deposit base.

However, I don't see BYFC as an attractive investment opportunity at this time, given that the company showed significant losses in the 2009-2012 period, that it does not originate its loans, that it has not adopted prospective loan loss allowances methods yet and that it carries millions in unrealized losses on its books that expose it to realized losses if it needed cash. I also do not understand the logic behind merging two localized banks in opposite ends of the country.

Note: Unless otherwise stated, all information has been obtained from BYFC's filings with the SEC.

Structure and historicals

Localized banks: BYFC after merger is geographically concentrated in Washington DC and California. There are no loan assets in other states.

Supposedly lean but expensive operations lead to operating leverage: BYFC has only three branches (two in LA, one in Washington), and 78 employees. The company sources its multifamily loans (60% of its loan book) from loan wholesalers. However, it has combined non-interest expenses of $24 million yearly. This high level of expenses is what previously deprived BYFC of profitability, increasing its operating leverage.

Cheap liability base: BYFC is mostly deposit financed ($780 million of $890 million interest bearing liabilities as of 3Q22). Their average yield for its liability base in the 9M22 was 0.28%. The company also recently received a $150 million equity injection from the Treasury in the form of preferred non cumulative equity paying the modicum of 0.5% to 2%, as part of a program to strengthen financial institutions that lend to low and middle income families. Ironically, after this cheap equity injection, BYFC's stock price collapsed, maybe because of the name of the program (Treasury Emergency Capital Program).

Well positioned in ESG factors: The bank is categorized as a public benefit corporation, meaning a for-profit corporation that also has public benefit objectives. This condition may improve the bank's participation in ESG funds, and has granted it the Treasury injection mentioned above. It could prove a positive advantage in the future as well.

A history of bad loans: Between 2009 and 2011, BYFC generated $44 million in allowances for loan losses, out of a $440 million book in 2009. These are massive losses on its book, which signal not so conservative and efficient loan allocation processes before the GFC. The allowances came as a surprise, compared with a level rarely above $1.5 million per year before 2008.

Current situation and perspectives

Lower operational leverage: One of the (potential) positives of the BYFC and FCBank merge is the dilution of a high fixed cost base in a bigger asset base. After more than doubling its loan book, BYFC's recurrent non-interest costs of $24 million represent about 2.1% of its interest earning assets. This figure averaged 3.5% for most of the past decade, making profitability more difficult to attain.

The loan book is slow to adjust to higher rates: The company's loan book is generating a lower yield in 3Q22 than in 3Q21, and only marginally above for the 9M22 vs 9M21 period (4.12% versus 4%). This is because mortgages have not been repriced yet. According to the company, 70% of its mortgages had adjustable rate provisions, but only after 3 to 5 years of fixed rates.

The company does not publish quarterly maturity information for its loan book. However, using FY21 information from the company's 10-K reveals that only $42 million matures this year, and only $132 million in the following four years. This means that the book will be very slow to reprice. It is also widely known that prepayments decrease when interest rates increase.

Higher spread generated by the security book: On the other side, securities and interest earning deposits have moved BYFC's interest margins up. The bank's security book ($313 million in 3Q22 versus $154 million in 3Q21) is earning 2.64% against 1.16% last year. Interest earning deposits earned 1.68% versus 0.19% one year ago.

Enormous unrealized losses on both the security and loan books may need to be translated to net income: The interest rate increase of 2022 generated a repricing of BYFC's assets. Because the bank carries most of those assets as held-to-maturity, it does not have to report the unrealized losses in net income.

For the securities book, BYFC has recorded $25 million of unrealized losses on other comprehensive income. Because most of these securities mature after five years, if the company ever needs to convert them to cash, and rates continue at current levels (or higher) the bank will need to move those losses to net income.

For the loan book, BYFC does not report an average maturity (a very serious lack of financial disclosure good practices). However, in the fair value disclosure section, the company values its loan book at $603 million using Level 3 mark-to-model, versus $722 million using the amortization method. This implies unrealized losses of $119 million that should be realized if the company needed to sell those mortgages to cover liquidity needs.

An antiquated loan loss provision system: BYFC uses the ALLL allowance method for its loan portfolio. This method is being phased out because allowances are charged to an estimate of incurred losses on the book. This greatly underestimates the portfolio risk. FASB requires BYFC to start using the prospective method (CECL) for fiscal 2023. The company has not provided an estimation of the difference in allowances that could be generated, but it could be significant, given the change in interest rates and deterioration of credit conditions. Also, the late adoption of this system shows lack of managerial disclosure culture, given that FASB approved CECL in 2016 and many similar sized banks already use the system.

Conclusions

Considering the current higher margin environment, BYFC is generating approximately $6 million in yearly after tax income (normalizing from 3Q22 earnings). This figure is not going to improve unless the company increases deposits and generates new loans, because BYFC's loan and securities book has long maturities and no repricing mechanisms in the short term.

On the other hand, there is a plethora of negative developments that could materialize: the unrealized losses in the loans and securities books, the losses generated by the new prospective provision system, the effective losses generated by tighter credit conditions, and the repricing of the company's deposit base.

In my opinion then, potential negative developments outweigh potential positive developments for BYFC. Trading at a current market cap of $70 million, or a multiple of 10 over its FY22E earnings, it does not provide an adequate current yield return for those perspectives. Therefore, I prefer to pass on BYFC for the time being.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.